Gone are the days when people would be content with their regular 9-5. Most young working professionals are looking for a passive way to improve their portfolio and be prepared for a crisis. Real estate may be worth considering here. Besides the high returns, real estate assets can be a key tool to reduce the tax burden. The significant deductions help offset tax liabilities on other investments. The government constantly wants to encourage real estate investments. Hence, there are several investing tax strategies that investors can benefit from.
Why is investing in real estate a great strategy for tax?
Investment growth:
When you purchase a real estate property, there is a significant investment growth potential. These assets can return significant profits on the initial investment, especially if there is time to appreciate. Whether you decide to put up a long-term tenant or create a vacation rental, there is a build-up on the equity. The longer you have the asset, the better the equity.
Most homes or commercial properties appreciate over time. Holding on to a property for a few years, given the market conditions are right, can lead to the property being more than the value you originally purchased it.
Better tax deductions:
Buying, selling, or maintaining real estate assets comes with many costs. But many of these can be written off on your yearly taxes. Real estate assets offer investors a long list of deductions, which includes mortgage interest, property taxes, maintenance and repairs, and depreciation. This helps decrease the taxable income which can reduce the owed taxes.
Many of the tax deduction strategies also provide access to more deductions. Structuring of assets, for example, allows deferring taxes with a 1031 exchange.
Diversification:
Several investment strategies in real estate allow you to diversify your portfolio. Investors use a common strategy to limit losses in several investment categories. Investing in multiple markets and property types also allows you to take advantage of different tax benefits while reducing the risks.
Strategies that help when investing in real estate
Understand the basics:
Understanding the foundational principles that apply to real estate investments in the US is imperative. Rental property incomes are subjected to ordinary income tax rates, while profits from the sale of real estate can be taxed as either capital gains or ordinary income, depending on the nature of the transaction.
- Ordinary Income vs. Capital Gains: Rental income is taxed at ordinary income tax rates, ranging between 10% to 37%. Capital gains tax rates, which apply to profits from the sale of a property held for more than a year, range from 0% to 20%, depending on your income level.
- Depreciation Recapture: When you sell a property, the IRS requires you to “recapture” the depreciation you’ve claimed. This means you may owe taxes on this amount, which is typically at a 25% rate. Understanding how depreciation recapture works is crucial for planning the sale of your properties.
Use depreciation to reduce the taxable income:
Accounting for depreciation is a real estate investing tax strategy. Properties that don’t appreciate in value can be used to deduct the loss on the taxes. This deduction will help lower the total taxable income while reducing the payable amount. There are many types of depreciation.
- Straight-Line Depreciation: Residential real estate is depreciated over 27.5 years, while commercial property is depreciated over 39 years. This means you can deduct a portion of the property’s value from your taxable income each year.
- Bonus Depreciation and Section 179 Expensing: Under the current tax laws, you can accelerate depreciation for certain property improvements. The bonus depreciation and Section 179 expensing allow you to write off a large portion of the cost of new assets like appliances, HVAC systems, or roofing in the year of purchase.
- Cost Segregation: This involves separating the cost of personal property from the real property. By doing so, investors can depreciate certain components of a building over 5, 7, or 15 years, instead of the standard 27.5 or 39 years. This results in larger depreciation deductions in the earlier years of ownership.
Use deductions to your advantage:
There are many tax deductions on the real estate you own. These are mostly expenses you bear to maintain the properties. The different areas of deductions include:
- Mortgage Interest: Interest on loans used to acquire or improve rental property is fully deductible. This can be a substantial deduction, especially in the early years of a mortgage when interest payments are higher.
- Property Taxes: Property taxes paid on rental property are deductible as an expense against rental income.
- Operating Expenses: Expenses like utilities, maintenance, repairs, property management fees, and insurance are all deductible. Keeping detailed records of these expenses is crucial for maximizing your deductions.
- Travel Expenses: If you travel to manage your properties, travel-related expenses can be made deductible, including airfare, lodging, and meals. But these expenses should be directly related to the management of your properties.
Plan for the impact of the passive activity loss rule:
Real estate investments can lead to losses, especially in the early years of ownership. However, the IRS classifies rental real estate as a passive activity, meaning losses from these activities can only offset income from other passive activities. These are not inclusive of incomes like wages or salaries.
- The Real Estate Professional Exception: If you qualify as a real estate professional under IRS rules, you can treat your rental activities as non-passive. This will allow you to offset losses against your ordinary income. To qualify, you must spend more than 750 hours per year and more than half of your working time materially participating in real estate activities.
- Grouping Elections: You can elect to group your real estate activities as a single activity for tax purposes. This can make it easier to meet the material participation requirements and utilize passive losses.
- Stay informed on the changes in the tax laws: The US tax code is complex and changes frequently. Staying informed about tax law changes and consulting with a tax professional are critical steps for real estate investors looking to optimize their tax strategies.
- Tax Cuts and Jobs Act (TCJA) Impact: The TCJA introduced significant changes to the tax treatment of real estate, including the introduction of the 20% Qualified Business Income deduction for pass-through entities, changes to depreciation rules, and the establishment of Opportunity Zones. Understanding these changes can help investors plan better to reap optimum benefits.
- Potential Future Changes: With the potential for future tax law changes, especially related to capital gains, estate taxes, and 1031 exchanges, it’s important to keep abreast of legislative developments and adjust your strategies accordingly.
Having an expert by your side can be effective in real estate taxation planning. When you outsource your needs to a professional team who are updated with the changing laws and legislations and can help you meet deadlines and maximize the returns.
Finsmart Accounting has been helping CPA and accounting firms for the past 17 years in 7+ countries, catering to their accounting and tax needs. To know how we can help, write to us at connect@finsmartaccounting.com.
Maanoj is Co-founder & Director of Growth Strategy & Alliance at Finsmart Accounting. He is an Outsourcing Expert, a People Champion, and a Dynamic Leader with strong Business Strategy and Scaling-up experience. He has incubated businesses, sold & exited ventures; helped build strong enterprises in very diversified verticals like Fintech, HR & Consulting spaces in various CXO capacities over the last 20 years.
